Subprime mortgages, ice cream, and horse apples

A few countries are rich, and will get richer; many countries are poor, and will in all likelihood stay poor.  What factors correlate most significantly with a nation's ability to become wealthy and continue to grow wealthier? 

Eric Beinhocker calls it "Social Technology."  Citing recent work by William Easterly and Ross Levine, he says it includes at least five items worth remembering:

• property rights;
• rule of law;
• a well-organized banking system;
• economic transparency; and
• lack of corruption.

As he noted:

Even countries with few resources and incompetent governments did reasonably well if they had strong, well-developed Social Technologies.  On the flip side, no countries with poor Social Technologies performed well, no matter how well endowed they were with resources or how disciplined their macroeconomic policies were.  [from The Origin of Wealth, p. 261.] 

The USA's guardianship of those and other Social Technologies goes a long way to explaining its wealth.  But it's a big mistake to think we can't get better at it.  Recent actions in the monetary arena, to shore up liquidity in the banking system, suggest to me that better transparency is in order for the mortgage lending and derivative businesses. 

The problem is not so much that lenders loosened up their criteria enough to enable lower income families to purchase homes.  That, in theory and in aggregate, is supposedly a good development for those lower income folks.  The competent lenders took the extra risk into account when they priced the loans; the incompetent ones (and there seem to be many) deserve to go under; culling incompetent deadwood is a definite positive for the economy. 

Nor is the problem related to the size of the subprime default exposure.  Many point out that 14% of mortgages are subprime, and 14% of those might go into default.  That means that 1.96% (14%x14%) of mortgages could be subprime defaults.  Not a big number.

No, the real problem is the lack of transparency into batches of mortgages that were bundled and then sold as one big package.  How much of a risk is the whole package if the portion of risky subprimes is buried in the total?  Answer: It's hard to tell, because of the lack of economic transparency. 

Would you want to be a buyer when you can't gauge the risk of what you're buying?  Neither does anybody else, and that's why that market is hardly moving.  Sellers can't sell, because nobody wants to risk buying. 

Reminds me of what a wise old man told me two generations ago:

When you mix ice cream with horse apples, it doesn't make the ice cream taste better. 

Economic transparency is a social technology we should now be able to get better at in the mortgage lending and derivative business—now that we've learned a lesson the hard way. 

Comments

[Counter Revolutionary]

Steve, do you think most are city dwellers and don't know what a horse apple is? Yup! I agree.

Now then, WaPo has an article, "For Wall Streets Math Brains, Miscalculations"
http://www.washingtonpost.com/
wp-dyn/content/article/2007/08/20/AR2007082001846.html?hpid=topnews

which supports your call for transparency. It appears the hedge funds most hurt were the quants, "quantitative equity" and many use just a handful of advisory firms using math models for recommending investments. Moreover, the models used by these advisers seem to result with very similar investing recommendations. In comes a day with extremes, outside the models' ranges, and they recommend selling.

These very large firms, using the same investing strategies are trying to sell - wait for it- the very same equities. The verb is exacerbating.

Some of the problem is the use of these super secret "quant" models and the handful of companies advising these very large investment firms. In essence many of these large funds tried leaving the market using the same door. By days end confidence in their own funds was dropping and their selling created the liquidity problem.

Sub-prime mortgages may be the catalyst, but brainiacs may be the cause. Maybe making the use of the models, not the models themselves, and the companies advising them and their core investment strategies should be made public. Then, at least investors may be able to choose when to go into a similar market (funds using only one strategy with slight, very slight, variances.) Not too diversified is it?

[Bob]

I recall a time when warrants, options, short selling and convertible bonds were considered high risk investments.

Nowadays, they seem relatively tame.

It was just a few years ago that Enron cratered. Many people bought the stock but had no idea of how Enron made money. If you ever read a quarterly or annual report, it was a mind boggling experience.

I suppose this lesson will be learned...for a while anyway. There will be another complex and confusing financial instrument down the road. There always is.

[Fersboo]

Steve,

I worked for a year with WellsFargo in their Remic tax office and saw every prospectus issued for their (owned or managed) mortgaged-backed securities (derivative). I'm no expert on derivatives, nor do I have anything more than an 101 and 102 level understanding of economics, but from my tax and financial accounting education and experience, risk is fully highlight making up a majority part of the prospectus.

The prospectus lists the types of loans, the categories of the mortgagees, the geographical locations of the mortgages, etc. Someone would be hard pressed to prove that a reasonable person could not make a risk determination based on the information provided by the mortgage banks.

I agree with you that the deadwood lenders should be removed as it improves the business, but also think that many borrowers are at fault also and there shouldn't be too much sympathy for their bad choices(I also don't feel sorry about the Enron employees that knew about the fake trading floor but invested in Enron stock, but that is another story). I purchased a 30 year-old home in 2002 for $200k in the Annapolis area. New homes in this area are two to three times larger and start in the $800s. I am secure in the fact that I took the safe route and bought the smaller/older home and am not in debt to my eyeballs (it's about up to my waist, but I'm not worried).

[rufus]

And, it just RUINED the taste of the Ice Cream. It's about over, now, though. With a worldwide economy in the $50 Trillion, range, our biggest concern next month will still be the cost of gasoline, not mortgages.

[Andy]

Steve,

You usually have a good knack for explaining things in layman's terms, but once in awhile it goes way over my head. I think I have a good understanding of liquidity, but the rest of it lost me.

How do you define economic transparency?
How and why did you make the jump between social technologies in poor countries to economic transparency in the housing market?

Also, that quip about ice cream and horse apples made me queasy.

[Ethyl Added]

Lack of transparency is part of the problem but hardly the root, in my opinion. The root of the problem is (or was) too much easy credit. Subprime is getting the limelight now, but wait for it, there's more shocks coming. Mortgage brokers aren't the only ones who misprice risk in the face of vast, easy, effortless credit.

[Big Daddy Matty]

Great article, Steve, but I think you (or your source) got the maxim wrong. Shouldn't it be "When you mix ice cream with horse apples, it doesn't make the _horse apples_ taste better"?

[JJ]

Yes, please do elaborate on what you mean by transparency specifically, with an example or three. I think hedge funds and institutions have and had a pretty good idea of what they were getting into with MBSes. Especially with the resources (people to look at lengthy, detailed disclosure/prospectuses).

Also, why did you give kudos to the Fed's intervention with liquidity? I know this should have been posted then, but I'm a little baffled as I've thought about it for a day. You see, you cite that it's a good thing for the deadwood subprime lenders to washout/get burned, but why not the overreacting institutions and retail investors who are freaking out about 500Bln in subprime loans (100% of which will *not* default, but let's say they *all* do) in a $13 *Trillion* dollar economy. The S&L crisis was almost exactly the same size back in the 80's, and it was hardly a hiccup globally or domestically, and that was when we were what, a 6-7 Trillion dollar economy?!

Why on earth is the sky falling here, I'm not seeing it? Why so many calls for legislation or regulation? Markets have fixed themselves in the face of bigger crises.

[Fat Man]

"• property rights;
• rule of law;
• a well-organized banking system;
• economic transparency; and
• lack of corruption."

Does China have any of these? Why are they doing so well?

[Steve]

Fersboo:
All the insiders I heard on CNBC during the last few days say the mortgage and derivatives market is simply not functioning well, due primarily to the difficulty or inability to unravel the bundles (some supposedly rated AAA) to get at the true value and risk.

Also, nobody should think the only victims are the buyers. Mortgage fraud has been happening nationwide (that's where the fraudulent buyers stick it to lenders who are less than diligent at due diligence).

Andy:
You're right, this one got a little technical, but it takes some understanding of the Fed's mechanics to understand why there was a near-freeze-up last week. "Economic transparency" according to The Economist is "the availability of prompt and complete information about trades and prices." Lack of transparency is a detriment to the wealth creation process, as has been demonstrated by poor countries every day for at least three thousand years.

Matty:
I've never tasted any, so I'll have to take your word for it.

JJ:
Apparently several hedge funds underestimated the risk. They're having to sell their good stuff to meet customer withdrawal demands, because they can't sell their questionable stuff. And it looks like the sky is not falling any more; the reason it looked like it might, before the Fed jumped in and calmed down the emotions, was the liquidity crunch. Businesses can show profits, or losses, on their P&L for years and years, but (as another wise man said) "when you run out of cash they take you out of the game." That came close to happening last week.

Fat Man:
China has a billion peasants living in abject poverty. When their per capita income increases by a few yuan, it looks like a big growth rate (percentage-wise).